"I view derivatives as time bombs, both for the parties that deal in them and the economic system. Basically these instruments call for money to change hands at some future date, with the amount to be determined by one or more reference items, such as interest rates, stock prices, or currency values. For example, if you are either long or short an S&P 500 futures contract, you are a party to a very simple derivatives transaction, with your gain or loss derived from movements in the index. Derivatives contracts are of varying duration, running sometimes to 20 or more years, and their value is often tied to several variables."

- 2002 Berkshire Hathaway Annual Report

The above quote regarding derivatives should be ringing a bell for most Buffett followers. Both Buffett and Munger have revealed deep concerns regarding financial derivatives. What has not been discussed extensively is how Warren Buffett (Trades, Portfolio) used those time bombs in his favor, especially when it comes to lowering his purchase prices of common stocks of the companies he was trying to acquire a major stake in.

Before I proceed, I want to make sure that readers, especially those less sophisticated investors, understand that shorting derivatives, in this case put options, can be extremely dangerous and should be avoided entirely if you lack the knowledge and experience in using them. Buffett doesn’t use them very often but when he does, the results have been more than satisfactory.

The strategy Buffett uses is shorting put options. As a general note, a put option gives the buyer the option to sell the underlying stock at a certain price on a certain date. Consider a put option with an exercise price of $10 and an expiration date in 30 days. Let's assume the underlying stock was trading at $12 when you purchased the put option. If in 30 days the stock dropped to $8, you, as the option buyer, can still sell the stock at the strike price, or $10 in this case. By using a put option, you effectively hedged the downside risk for 30 days.

Now things get a little tricky when you short a put option. As the writer of the put option, you are essentially selling the right of “selling the underlying stock” for a premium. You receive cash for the premium. If the underlying stock in 30 days stayed above $10, you simply keep the cash. However, if the underlying stock in 30 days dropped to say $5, you will be effectively obligated to buy the stock at $10 per share, minus the option premium you received, even though the stock is only trading at $5 per share.

The way shorting put options works is a little like writing an insurance premium. In practice, of course they are very different but conceptually, they both involve getting paid for taking on some risks that may or may not materialize. And if you price the contracts with enough margin of safety, you are very likely to benefit.

Now let’s take a look at how Mr. Buffett used put options to lower his purchase price of Coca-Cola (KO). In April 1993, Buffett shorted 30,000 contracts (equivalent of 3 million shares) of out-of-the-money Coca-Cola put options for $1.5 per piece. These options had an expiration date of Dec. 17, 1993 and the exercise price was $35. He then added 20,000 more contracts since. By shorting the put options, Buffett got paid $7.5 million in cash up front. If Coca-Cola stays above $35 per share on Dec. 17, he keeps the cash. If Coca Cola drops below $35, he can effectively purchase the stock at $33.50 ($35-$1.5 option premium), which was a great price anyway. It’s a win-win situation.

Buffett did the same thing for Burlington Northern Santa Fe. During the third quarter of 2008, National Indemnity Company, which is a subsidiary of Berkshire Hathaway (BRK.A)(BRK.B), sold almost 5.5 million shares of put options on Burlington Northern Santa Fe exercisable before Dec. 8, 2008, with a strike price of $80 a share. It was a lot of trouble tracking down the SEC filing for those options, but I was able to find the following document evidencing the exercise of BNI options.

Shrewd readers may have realized that the timing of the option purchase and exercise almost coincide with the market turmoil between 2008 and 2009. Option prices spike when volatility spikes. Therefore, as an option writer, you can expect to get a hefty premium during turbulent times. Not surprisingly, this is what Buffett did and those options saved him hundreds of millions of dollars when purchasing BNI.

You may think, that's great but KO and BNI options aren't that material to Berkshire. True, but the following option trade will blow your mind. Let's revisit Berkshire's 2008 Letter to shareholders:

We have added modestly to the “equity put” portfolio I described in last year’s report. Some of our contracts come due in 15 years, others in 20. We must make a payment to our counterparty at maturity if the reference index to which the put is tied is then below what it was at the inception of the contract. Neither party can elect to settle early; it’s only the price on the final day that counts.

To illustrate, we might sell a $1 billion 15-year put contract on the S&P 500 when that index is at, say, 1300. If the index is at 1170 – down 10% – on the day of maturity, we would pay $100 million. If it is above 1300, we owe nothing. For us to lose $1 billion, the index would have to go to zero. In the meantime, the sale of the put would have delivered us a premium – perhaps $100 million to $150 million – that we would be free to invest as we wish.

Our put contracts total $37.1 billion (at current exchange rates) and are spread among four major indices: the S&P 500 in the U.S., the FTSE 100 in the U.K., the Euro Stoxx 50 in Europe, and the Nikkei 225 in Japan. Our first contract comes due on September 9, 2019 and our last on January 24, 2028. We have received premiums of $4.9 billion, money we have invested. We, meanwhile, have paid nothing, since all expiration dates are far in the future. Nonetheless, we have used Black- Scholes valuation methods to record a yearend liability of $10 billion, an amount that will change on every reporting date. The two financial items – this estimated loss of $10 billion minus the $4.9 billion in premiums we have received – means that we have so far reported a mark-to-market loss of $5.1 billion from these contracts.

One point about our contracts that is sometimes not understood: For us to lose the full $37.1 billion we have at risk, all stocks in all four indices would have to go to zero on their various termination dates. If, however – as an example – all indices fell 25% from their value at the inception of each contract, and foreign-exchange rates remained as they are today, we would owe about $9 billion, payable between 2019 and 2028. Between the inception of the contract and those dates, we would have held the $4.9 billion premium and earned investment income on it.

By now, it should be clear that despite his general distaste for options and more generally derivatives, Buffett sold options repeatedly to either make money or lower his purchase price. This is rarely discussed and maybe for good reasons. I will not go into the details of those option trades, but interested readers can go to sec.gov and go through Berkshire's filings (including those of its subsidiaries). You will be surprised by what you can find.

Again, my goal for this article is to show the readers that if used properly, options can be profitable, or can serve you well by reducing purchase prices. However, a sound understanding is absolutely required if you want to mimic Warren Buffett (Trades, Portfolio).

@Mslatnh: contract size may vary considerably between different option contracts, depending on the price of the stock. I wasn't able to find NASDAQ contract specifications (does anyone know where to find them?), but I can provide an example for German Eurex: e.g. the table on page 145 of the following document shows contract sizes of options traded at Eurex: [www.eurexchange.com]

@Mslatnh "Now let’s take a look at how Mr. Buffett used put options to lower his purchase price of Coca-Cola (KO). In April 1993, Buffett shorted 30,000 contracts (equivalent of 3 million shares) of out-of-the-money Coca-Cola put options for $1.5 per piece."

fantastic article! Would you happen to know good places to look up options price history? I don't think Black Scholes captures all the value of common stock as valued by a competent value investor. You do give up liquidity though when you short put options since you might be called on it.

Disclaimers: GuruFocus.com is not operated by a broker, a dealer, or a registered investment adviser. Under no circumstances does any information posted on GuruFocus.com represent a recommendation to buy or sell a security. The information on this site, and in its related newsletters, is not intended to be, nor does it constitute, investment advice or recommendations. The gurus may buy and sell securities before and after any particular article and report and information herein is published, with respect to the securities discussed in any article and report posted herein. In no event shall GuruFocus.com be liable to any member, guest or third party for any damages of any kind arising out of the use of any content or other material published or available on GuruFocus.com, or relating to the use of, or inability to use, GuruFocus.com or any content, including, without limitation, any investment losses, lost profits, lost opportunity, special, incidental, indirect, consequential or punitive damages. Past performance is a poor indicator of future performance. The information on this site, and in its related newsletters, is not intended to be, nor does it constitute, investment advice or recommendations. The information on this site is in no way guaranteed for completeness, accuracy or in any other way. The gurus listed in this website are not affiliated with GuruFocus.com, LLC.
Stock quotes provided by InterActive Data. Fundamental company data provided by Morningstar, updated daily.